Junk Yields Tempt, but Watch Out

--risks to corp bonds a.large volume issuance of Treasury might increase Treasury yields, disfavoring investment grades b.weak fundamentals will lead to higher default rate, to the point where yields could not be offset the loss. c.increasing volume of high yield issuance might increase yield. Despite Rally, Fundamentals Signal Trouble, Especially on Lower End By TOM LAURICELLA and JODI XU Even after a huge junk-bond rally this spring, yields are at historically lofty levels. That might make the high-yield market appear attractive, but some are urging caution. Record-high defaults, low recoveries on bad loans and a potential wave of new debt suggest the wide yield gap between high-yield bonds and U.S. Treasurys of roughly 11 percentage points is well-deserved. That is especially true for the lowest-quality debt, where a weak economy and credit crunch remain a problem for struggling companies. "It's going to be quite challenging to do much better," says Edward Altman, a New York University finance professor who specializes in bankruptcy analysis and the high-yield bond market. "The fundamentals are still not strong." Such an environment should favor buying higher-quality junk bonds and the lower rungs of investment-grade debt -- especially financials -- where yields are still attractive but the ability to raise capital is stronger thanks partly to government help. "You want to pull back on risk and run a more conservative portfolio," says Mark Kiesel, global head of the corporate-bond portfolio group at Pacific Investment Management Co. A quality focus would be the opposite of the strategy that has worked best since high-yield debt hit bottom starting late last year. While the broad high-yield bond market rallied 42% from its lows, debt rated triple-C by Standard & Poor's posted gains of 65% before falling a bit in recent days, according to Merrill Lynch. In contrast, double-B-rated debt, the upper end of the junk-bond spectrum, gained 35% from its trough. Investors chased the junk-bond rally by pouring money into high-yield-bond mutual funds, which have taken in more than $9 billion since March, according to Morningstar Inc. The quality-emphasis approach has its risks. Investment-grade bonds move more in tandem with U.S. Treasurys than high yield. Junk bonds closely track stocks. Should the economy show real signs of improvement, stocks stage another rally and Treasurys fall, a higher-quality corporate-bond portfolio could lag. For now, stocks are closing out the first half of 2009 in a relatively tight range after staging a sharp rebound. The Dow Jones Industrial Average finished last week at 8438.39, up 29% from its March 9 low, but is down 6.6% from its 2009 high reached Jan. 2. To a large degree, junk's biggest rally since 1991 was a reversal of the extremes seen after Lehman Brothers collapsed. "There was an unprecedented fall and an unprecedented rise," Mr. Altman says. "But whenever you're dealing with market psychology and a herd instinct, you get fluctuations that are more dramatic than perhaps the fundamentals would imply." Mr. Altman expects spreads to rise toward 12 percentage points over Treasurys amid continued heavy defaults. By his calculation, the default rate on high-yield debt rose to 7.2% during the first five months of this year from 4.6% in 2008, which is roughly the long-term average. He expects the default rate to hit a record 14% one year from now. Even if the economy recovers during the second half of the year, "I don't think the default rate is going to trail down," he says. Meanwhile, creditors are recovering a lower proportion of their money in defaults. Mr. Altman forecasts recoveries will be between 20% and 25% for bonds, on par with levels hit during the 2000-2002 collapse of the junk-bond market. At Metropolitan West, the belief is that the lowest-quality companies are vulnerable after rallying the most. "We find investment-grade financials more appealing," says Tad Rivelle, MetWest's chief investment officer. Banks such as Citigroup are offering historically high yields of 3.5 to four percentage points above Treasurys. Pimco's Mr. Kiesel also thinks financials are appealing, citing debt issued by J.P. Morgan Chase, Barclays and Rabobank. Within high yield, Mr. Kiesel is avoiding companies heavily reliant on U.S. consumer spending. Instead he's favoring utilities, health care and cable. In addition, he is slightly biased toward energy and metals, based on the theory that the massive effort by central banks around the globe will result in upward pressure in commodity prices. Another question mark for high yield is possible heavy issuance of new debt. During April, May and June, nearly $40 billion in high-yield bond offerings came to market. Analysts believe there remains a significant need for companies to raise cash, especially from those looking to shift debt from short-term loans into longer-term maturities. If that pace of issuance were to continue, it would be on par with the record $128 billion issued during 2007. During the spring rally there was initially little issuance, and subsequently companies found willing buyers for their debt, notes Eric Takaha, a portfolio manager at Franklin Templeton. "To the extent high-yield supply remains high and if you see a larger proportion of that supply coming from somewhat lower-quality issuers, then it will be important that investor demand and cash inflows remain strong," says Mr. Takaha. "Otherwise the supply could then have an incrementally negative impact on the market." Write to Tom Lauricella at tom.lauricella@wsj.com